Retiree Portfolios in the New Normal: The Envelopes Strategy, Pt. 2

Clients will need to undertake a paradigm shift in thinking, redesigning their portfolios to produce predictable income in the new normal.

By Philip J. Romero|August 08, 2017 at 08:18 PM

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One of an adviser’s core challenges is to educate clients about swerving from aggressive accumulation, to designing their portfolio for measured decumulation. This is captured in the title of my recent book co-authored with Riaan Nel: It’s the Income, Stupid!

This two-part column introduces the profound paradigm shift clients will need to undertake, redesigning their portfolios to produce predictable income in the “new normal” of miniscule interest rates. We hope you share it with your clients, so that they better understand your advice.

Part One of this column introduced the idea of distributing our earnings into “envelopes,” or establishing mental accounts, that devote pieces of our overall assets to different purposes. We may have, for instance, mental accounts for housing (rent or mortgage), transportation, food, gifts, and luxuries like a vacation. Many households aspire to have a “rainy day” fund for emergencies, although for many it is only a hope. Each account may be invested differently. A near-term goal envelope may be targeted to a goal that is still a few months or years in the future, and a really long-term goal envelope, like retirement savings.

This column continues showcasing the envelopes strategy of investing.

Maintaining the Envelopes

The envelopes approach is a model of simplicity. You determine your time frames for each envelope and segment your investments accordingly, with the very safe investments in Envelope 1, progressing along the risk continuum, sequestering the most volatile and risky investments to Envelope 3, which you don’t need to touch for 10-plus years.

The foundation of the approach is to maintain a safe, principal-protected pool of assets at all time. Things get a little more complicated when you have to consider how to move assets between the envelopes as the first envelope’s assets are spent down.

Suggested Approach

Clients should focus first on refilling Envelope 1 with all income distributions from the other two envelopes except when you are opportunistically taking advantage of depressed prices to reinvest. When the final year of Envelope 1 approaches, Envelope 2 assets are liquidated to be shifted into Envelope 1. Every so often you will liquidate highly appreciated assets to move to Envelope 1 and/or 2.

Following this approach the portfolio will become more aggressive over time as you spend down Envelopes 1 and 2, increasing the percentage of your entire portfolio allocated to Envelope 3. Recent research has shown that increasing your equity allocations as you progress through retirement offsets the risks to your portfolio of living longer than anticipated, and allows you to exponentially increase your income later to adjust for inflation: known as “the inverse glide path”. Only when Envelope 2 is fully depleted to fund Envelope 1 will the smart investor liquidate some Envelope 3 assets to recreate new Envelopes 1 and 2, as well as determining new time frames.

Advantages of the Envelopes Approach

There are a number of advantages to the envelopes approach:

It smooths your spending in volatile markets. Considerable economic research suggests that “consumption smoothing” is the best way to approach long-term financial planning. (Consumption is what economists call spending.) Milton Friedman won an economics Nobel Prize in part for demonstrating this.

Smoother assured income reduces the risk that you will panic and sell in a down market.

Drawing down your growth envelope when there is significant appreciation or when Envelope 2 is almost depleted (to refill the downstream buckets) forces periodic rebalancing and reduces the risk that euphoria will keep you in a market bubble too long.

Finally, retirement is supposed to be a time without worry. Regularizing your income, to simulate a paycheck, keeps you from losing sleep over market gyrations. Less stress means a longer and happier retired life.

While two-envelope systems are possible (encompassing only Envelopes 1 and 3 in our scheme), in our view that does not really insulate your annual spending from market volatility, and your own impulses. A three-bucket system creates a buffer (Envelope 2) between your long-term Envelope 3 and your liquid Envelope 1, which will act as a shock absorber on your overall spending. The reduced stress may help you live longer.

The Power of Envelopes

A common way to appraise an investing technique is back testing. A portfolio strategy is simulated using historical data on asset returns, to compare its performance with other strategies. Back testing has pitfalls, including hindsight, but it is a reasonably rigorous approach.

In 2010 Morgan Stanley examined several alternative retirement withdrawal strategies under 5,000 Monte Carlo cases. It compared the envelopes approach to other more conventional strategies, and considered withdrawal horizons (the number of years over which withdrawals would occur) of between 30 and 50 years. Similar analyses by Morningstar have also demonstrated the envelopes approach’s superiority.

In all cases the envelopes approach—termed “buckets” by Morningstar and “time-segmented baskets” by Morgan Stanley— had the greatest probability of success, preserving some value in the portfolio at the end of the withdrawal period in 95% to 96% of the 5,000 scenarios examined. Other conventional approaches, such as withdrawing a constant amount from an unsegmented portfolio, were inferior, but only modestly: successful in 92% to 93% of the Monte Carlo scenarios.

Success better than 19 of 20 times is not a guarantee, but it may reassure you enough to avoid panic selling at the worst times.

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